If you have been following the financial news, you will have seen the name Bear Sterns a lot lately. The fifth biggest investment bank on Wall Street passed into history over the weekend, first rushing to the US Federal Reserve for an emergency bailout and, a day later, being bought for a song by JP Morgan Chase. Many have noted the historical irony here: it was just on a hundred years ago that the real-life John Pierpont Morgan bailed out the US banking system in the "Panic of 1907".
The answer is a mix of simple human emotions like fear and greed, and system failures like lax lending regulations and opaque financial instruments. Banking is such a complex system that regulators are typically a step behind the cutting-edge innovations of the financial rocket scientists, like Collaterised Debt Obligations. And lax regulation has largely caused the current crisis, owing to the insane lending practices of many of America’s largest financial institutions, and the dawning realisation that many of these "sub-prime" loans – and the financial instruments they had been packaged into – were now worthless.
Another day, another multi-billion dollar bailout. Today the Federal Reserve cut US interest rates by three quarters of a percentage point in its latest attempt to stem the bleeding. Wall Street surged in early trading yesterday. But by today the short-lived rally was over, and Wall Street and the ASX roller-coastered back into the red.
As the many panics since the South Sea Bubble of 1720 show, crisis in banking systems is what US sociologist Charles Perrow has called a "normal accident". In his book of the same name, Perrow examined air transport, the Challenger accident and nuclear reactor safety to demonstrate that the combination of human error and complex systems can combine to produce unforeseen disaster. While such accidents might be uncommon, there were also predictable on 30 to 40 year time-scales. Of course, the last US banking crisis ("Savings and Loan") was only 20 years ago, while the Long-Term Capital Management crisis was only ten. These infrequent but regular meltdowns in complex systems captures Perrow’s idea of "normal accidents".
So why are the US Fed, our Reserve Bank and indeed the rest of the economic establishment so concerned about the crisis? The reason is that it has dried up practically all the liquidity on Wall Street, and with it a substantial part of the global funds available to borrowers. In simple terms, banks refused to lend money to anyone – and especially not each other – because they could no longer be sure of the risk they were getting into. This caused liquidity to suddenly dry up last August. Despite regular bailouts and cash injections from central banks, the markets have never really recovered. Suddenly cash was king – banks began to hoard as much cash as they could in order to shore up their balance sheets. In Australia, this dramatic change in the lending environment quickly caused the downfall or near downfall of several highly leveraged firms who could no longer roll over their short-term debt: MFS, Centro, Allco and ABC Learning.
Perrow’s book also introduced the idea of the problem of "linkage": the tendency of systems to be linked together in unforeseen and catastrophic ways. This happened at both Three Mile Island and Chernobyl, where backup systems that had been thought "fail-safe" broke down because of unexpected interactions with preceding events. In this crisis, CDOs were the linking instruments that "coupled" a small number of bad loans in the mortgage sector to the rest of the US financial system.
Late last year, technology writer Bryant Urstadt wrote a long and fascinating feature about the rocket scientists who design and manage these financial instruments. Many of them were worried even then. He quotes one hedge fund professional, quantitative financial modeler Richard Bookstaber, as saying "we have gotten to the point where even professionals may not understand the instruments".
"Nobody knew that what happened in the sub-prime market could affect what was going on in the quant equity funds," he says. "There’s too much complexity, too much derivative innovation. These are the brightest people in the business. If it could happen to them, it could happen to anyone. No one could have predicted the linkage."
In other words, the crisis is still far from over. Some are now worrying about doomsday scenarios such as the US Federal Reserve itself failing. The Fed is running out of funds – a further bailout on the scale of last week’s action would seriously stretch its resources. After that point, stabilisation may require the US Treasury to step in and effectively take on trillions of dollars of bad debt. It’s not a comforting thought.
No wonder Australia’s Reserve Bank stepped in this morning to add liquidity to the local markets.
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